Will the Horse Drink?

Almost everybody prefers inflation to deflation. Certainly, economists and politicians do. And the general public prefers inflation too. Why do you think Viagra sells so well? But you have probably noticed that those TV ads for drugs to cure erectile deflation warn that if you experience medically induced concupiscence for several hours, you should see your doctor.

And that’s exactly our economic dilemma these days: we are printing so much money to conquer deflation that we might be hit with fearful inflation as soon as we recover. According to the Wall Street Journal, the United States has pledged to spend, invest, or loan as much as $10 trillion to fight deflation. President-elect Obama wants to toss in another trillion bucks soon, probably to be followed by much more. The government and the central bank will get some of this money back, but much of it could turn into inflation. The Federal Reserve has not only lowered short-term interest rates to almost zero but it has also run the monetary printing press to buy bonds so that long-term interest rates, particularly on mortgages, will come down.

To make sure that deflation doesn’t quickly morph into inflation, the Fed will have to be nimble to raise interest rates as soon as the economy appears to recover. It has never displayed such agility, partly for political reasons. Politicians love easy money; it’s like distributing booze to voters on Election Day.

On December 16, the Fed lowered the federal funds rate, the interest banks charge each other, to a range of zero to one-quarter of a percentage point — a big markdown from 1 percent and the lowest rate on record. But in some senses, it was meaningless: banks haven’t been loaning to one another, so the rate was effectively around zero already. Also, the Fed has already been buying bonds to bring long rates down. Bottom line: neither strategy has been working. The economy seems to get worse every day, and both consumer and producer prices are falling.

Monetary policy has clearly not whipped deflation. In their private moments, policymakers are afraid of a rerun of the 1930s. Why is deflation scary? Buyers delay their purchases, figuring that prices will be lower in the future. This leads to a down-spiral. Deflation encourages saving because money will be worth more in the future — the reverse of inflation’s incentive. As people save, they purchase less. The government and central bank want them to resume the old habits of borrowing too much to consume too much. “It’s not clear to me that we could or should make people consume more,” says James Hamilton, economist at the University of California, San Diego. “Running up the debt is part of the problem that got us here in the first place.” Amen.

Critics say that Japan tried zero interest rates to no avail during its 1990s depression. The money the Japanese government poured into infrastructure spending didn’t jump-start the economy either. But Todd Buchholz, San Diego author-economist with degrees from Cambridge and Harvard, says Japan is not such a good analogy. “I wrote an article calling their strategy ‘Hoover Economics,’ ” says Buchholz. “They raised taxes. The yen went up, and they couldn’t do much about it. It took years for them to recognize that their financial institutions were zombies that they wanted to keep propping up. It was a zombie economy.” Buchholz believes that the United States’ policy of driving down both short rates and long rates will succeed.

But others argue that this is not a credit crisis. It is a debt crisis. As in the 1930s, people do not want to borrow money to spend. Period. The Fed can pour money into banks, as it is now doing through several strategies, such as buying equity in the institutions, but it won’t work if the horse that is led to water simply won’t take a drink. In trying to get consumers to spend, the central bank will in effect be pushing on a string.

Some years back, the government and its central bank decided — secretly — that the best strategy would be to induce inflation of asset prices instead of inflation of goods and services. Everybody would be happy. So first we had a stock market bubble, then a housing-price bubble, then a commodities bubble. All the bubbles popped ignominiously, wiping out investors who would probably have preferred having their grocery and gas prices go up. “I don’t remember another time when we had a [tech-stock], housing, and commodities bubble in such a short period of time [as we did leading up] to 2008,” says Buchholz. “I hope we learned our lesson.” He doesn’t think the Treasury and Fed are plotting another bubble, even though interest rates are lower now than they were during the other crazes. He doubts that the people will stand for it. (Some argue that point.) But Buchholz doesn’t foresee consumer inflation: “It’s going to be a trick, but I don’t believe high inflation is baked in the cake.”

Ross Starr, economist at the University of California, San Diego points out that “in the 1930s, interest rates were near zero, the banks were very liquid, had immense cash reserves, but there was a shortage of lending opportunities.” People just didn’t want to borrow; they were too insecure — hardly surprising, with unemployment so high. Starr concedes, “It’s perfectly possible that today the strategy of quantitative easing [running the monetary printing press] and zero interest rates will fail.” But he doesn’t think so. He thinks people now delaying real estate purchases will take advantage of lower interest rates. “Prices are now more reasonable; now we need the credit to permit them to buy.”

The federal government will pump money through the system by making direct gifts to ailing states, propping up unemployment benefits, financing public works that are already in the pipeline, and creating new energy programs. The trick with these infrastructural programs is to get the money into the system quickly. He agrees that “households are looking at their balance sheets; they were robust a few years ago because of real estate values and 401(k) values, and they may save money to replenish their balance sheets. But I hope there are enough consumers out there to buy homes that have been postponed.”

Response to post #1: I believe the recession will last into 2010, but not become a depression (3 straight years of recession). Why? Because consumers are doing the right thing: they are not buying and are building up their savings. That will cause pain in the short run (consumer spending is more than 70 percent of the economy), but the cumulative savings will help us beat this in 2010. But I worry about inflation once we have conquered deflation. The Federal Reserve's balance sheet is in tatters; it is printing money at a frenetic pace. Best, Don Bauder

Regarding Don Bauder's Story - Will the Horse Drink?

I agree with the opinion that we not only have
a Credit Problem, but we also have a Debt Problem.
In addition to that, I also believe that the U.S.
has a Job Problem and a GDP problem.

How did this happen? First we shipped our manufacturing
over seas for the purpose of cheap labor. This enabled
corporations to reduce the unit price of their merchandise,
so businesses such as WallMart would continue to purchase
them and sell them at lower prices. It kept the ball
rolling. People bought on credit, and big business
and stock holders made more money.

The next step was to lower interest rates and reduce
financial oversight, so people could refinance their homes
and purchase the big ticket items: Flat Screen TVs and new Cars.
When the refinancing slowed down, homes were sold to people who
could not afford them. I just love the term "Stated Income".

While all this was going on, our illustrious leaders
(Executive branch, Congress and Regulators) turned their
heads the other way.

Everything was done to line the pockets of the rich and
powerful in the "short run". Everyone ignored the "long
run" ramifications.

So when everything went to heck, what did we do? Mr.
Treasurer (Henry Paulson) threw money to the institutions
that were most responsible for this mess - the Bankers.

Quite frankly, I don't trust any of these guys, and I think
that the U.S. is in for an extended downturn. If the government
feels the need to pump money into the economy, I would like
to see it directed to industries that will create jobs,
bring back manufacturing and generate "long term" benefits
for the U.S. Infrastructure and Health Care are my first
two picks.

I still have a problem trusting the same bozos to distribute
money appropriately. This is where the new administration
comes in. Can Obama and gang get it done? I have a lot
more faith in them than I had in the Bush clan; however,
the proof is in the pudding.

Response to post #3: Yes, we have a debt problem more than a credit problem. We consumed more than we produced and borrowed the difference from abroad while we were sending jobs there. It was bound to crash. Economists who never saw the problem developing -- incredibly -- are now trying to get consumers to borrow and spend. But consumers, thankfully, are flipping them the bird. The consumers want to build their savings back up. That will cause pain in the short run, but is the only cure. And you are right: by throwing money at the banks and insurance companies, the government was making the mistake Herbert Hoover and the Japanese did. The money should have gone into thwarting foreclosures. But the authorities tried to pump up the Wall Streeters because they believed that derivatives would explode in a chain reaction, spreading havoc. But why had they not figured out that could happen before it did? These are the same people who argued strenuously, and successfully, against regulating the derivatives. They should be retired from public life. Alas, they are high up in the current administration as well as the one coming in. Best, Don Bauder

Last month I got this insane email from some lunatic who suggested that if the gummint handed out the $750 billion to every citizen over age 18, that most of the money ($300,000 and change each) would go directly into the economy's arteries and pump up the heartbeat of the nation (presumably literally and figuratively)and it would fly into banks and stimulate rampant spending. It would still end up in the pockets of the of the Worthy Gentlemen and Ladies at Court, and soon fatten them up to the megaton realm.

Shouldn't such heretics be burned at the stake? How DARE they suggest such a stupid idea? What I fear the most is that this idea will be emailed all over the country and We, The People will rise up and deman that it be done.

When you overpay bozos who strangle the Golden Goose (the consumer) you must be doing something right, eh? I'm glad I don't have any grandchildren. If you can't trust your banker, your broker, and your financial advisor, whom can you trust?

Response to post #7: Yes, the first comment is a work of art -- one of many by Fred. Tragically, one of the causes of our current downturn is excessive consumption and concomitant excessive debt. So heretics like your email correspondent want consumers to go back to overspending and overborrowing. The only way the U.S. will get out of this mess is for consumers to cut back spending for a significant period and build up savings. Once they have the savings, the economy can recover again. This will bring pain in the interim. But it will be a road out of the muck. Trying to pump things back up now will just dig us further into the slough. Best, Don Bauder

I see asset price deflation coupled with consumer price inflation, which with falling or stagnant incomes is going to squeeze the middle and lower classes very hard.

As Don points our, 70% of our economy is the equivalent of "taking in each other's laundry". Most of our nation's work doesn't really "make" anything...we're paid for being in the middle.

Those industries that DO produce real tangible goods that the rest of the world wants to buy should do well...except for one major problem.

The Fed and Treasury is borrowing other country's savings in a vain effort to re-inflate our domestic consumption bubble. So our foreign friends and trading partners don't have the available money, or a stable enough currency, to buy our real goods.

So, if you want a global macro-economic stimulus try this strategy:

Lend $850 Billion to OTHER nations so they can use it to stabilize our currencies and buy what we produce.

I believe the recession will last into 2010, but not become a depression (3 straight years of recession). Why? Because consumers are doing the right thing: they are not buying and are building up their savings. That will cause pain in the short run (consumer spending is more than 70 percent of the economy), but the cumulative savings will help us beat this in 2010.

Good post. There is no way we are beating this in 2009, out of the question. In fact with the job losses going up we are going to see MORE foreclosures, and that in turn will keep the chaos running throughout the financial system.

Only when we get the employment scene stabilized will we begin a recovery.

For jobs to become stabilized and for job growth, we need to drill into our elected leaders heads exactly what ronaldi has clearly stated- manufacturing/production of goods is the ONLY cure for our economic chaos.

Response to post #9: Beginning with the Reagan administration, the strategy was to have asset inflation (stocks, real estate, commodities) and not inflation of goods and services. People would be happy. But what Alan Greenspan did not fully realize that asset bubbles burst and cause severe unhappiness. He didn't even realize it after the 2000-2002 bear market in stocks. He created a second real estate bubble, and congratulated himself as the people basked in the faux wealth. But he never saw that unregulated and even unmonitored derivatives based on falsely valued real estate assets would cause grievous pain when the bubble burst. He was not alone in not foreseeing the consequences: Paulson, Bernanke, Summers, Geithner and almost everybody did not see what was coming. And look where they are now. Best, Don Bauder

Response to post #10: Right on: I will repeat it again: for decades, we consumed far more than we produced, borrowing the difference from foreign countries as we were sending jobs overseas. And today's leaders didn't see it then and are keeping their mouths shut now, partly because the press isn't putting the questions to them. Best, Don Bauder